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What is a Rollover?

What is a Rollover?

Client question:  What is a rollover?

Advisor answer:  The first thing I think of when someone says “rollover” is a dog following its owner’s command by doing a barrel roll.  Unfortunately, this is probably also what clients think when I suggest completing a rollover! The purpose of this month’s post is to demystify the “rollover.”  Put simply, a rollover is transferring funds from one retirement plan into another retirement plan.  The key is that this transfer can be performed without creating a taxable event (more on this below). You will most commonly look to execute a rollover after you have left your previous employer and are seeking to consolidate your investments. Although this article should give you a good grasp of the issue, there are many variables that go into the decision of whether to rollover or not to rollover.  Feel free to schedule a complementary consultation where I can give you a personalized recommendation.

Why should I execute a rollover?

The two primary reasons to execute a rollover are 1) you will likely have access to better investment options in your Individual Retirement Account (IRA) than you have with your employer-based retirement plan and 2) by rolling over funds to an IRA, you will not be subject to the extra “plan fees” you pay to the administrator of your old 401(k) plan.  Another great reason to rollover funds from your 401(k) is to consolidate your financial life and simplify things from an administrative perspective.

What is a taxable event?

Unless you are one of the very few people (I have never met one) who enjoys paying taxes, you will want to cross your “t’s” and dot your “i’s” when doing a rollover to avoid owing a big check to Uncle Sam.  In general, the least favorable course of action is to “cash-out” your employer-based retirement plan (e.g. 401(k)) and elect to have the funds sent to your bank account.  You might be thinking, “This rollover stuff is too complicated so let’s just send the money to my checking account where I’ll know what to do with it.” The outcome of “cashing out” your 401(k) is that the full distribution will be taxable at your ordinary income tax bracket AND you may have to pay a 10% penalty to the IRS for “pre-maturely” taking the money out of your 401(k) plan.  

How do I execute a rollover?

You can avoid paying income tax and the 10% penalty on your 401(k) distribution (or other employer-based retirement plans) by doing a rollover. Executing a rollover is as simple as asking the person in your benefits/HR department, “Please provide me the paperwork necessary to rollover my 401(k) to my IRA.”  After you receive the paperwork, you’ll need to know the account number of the Traditional IRA/Roth IRA that the funds from your employer-based retirement plan will be “rolling” into.  There is more on this in the section below.

It’s important to note that you can only execute a rollover after you have officially left your prior firm (i.e. separated from employment) or if you qualify for an in-service distribution.  The eligibility for an in-service distribution is dependent upon your employer’s particular plan document; however, this is usually only available for employees who are over 59 and a half.

Should I rollover to a Traditional and/or Roth IRA?

In general, you will want to rollover the funds from a “pre-tax” employer-based retirement plan to a Traditional IRA.  A Traditional 401(k) is an example of a pre-tax employer-based retirement plan. If you rolled over a Traditional 401(k) to a Roth IRA then this would technically be considered a “Roth Conversion” and the entire dollar amount would be taxable; however, this converted amount would not be subject to the 10% premature distribution penalty.

If you are rolling over a Roth 401(k), things get a little trickier.  In my experience, the risk is relatively high for “messing things up” by inadvertently causing the Government to send you a big tax bill.  Even though you might have a “Roth” 401(k), the fact is that some of this money is “Roth” money and some of it is “pre-tax” money. You need to be clear with your former employer’s plan administrator (these are the people whose contact information will likely be listed on the rollover forms) that you would like to rollover the Roth money in your 401(k) to your Roth IRA and the pre-tax money in your 401(k) to your Traditional IRA.  To get a little granular, the contributions you make as an employee and the earnings on the contributions should be rolled over to your Roth IRA; however, the contributions your employer makes to your 401(k) and the earnings on those contributions should be rolled over to your Traditional IRA.


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